May 4 (Bloomberg) -- Citigroup Inc., girding for results of the Federal Reserve’s bank stress test, may try to wring capital from private investors instead of U.S. bailout funds as a way of bolstering equity without ceding control to the government, people briefed on the matter said.

Regulators have indicated to the New York-based bank, which got a $52 billion rescue last year, that another taxpayer-funded cash infusion won’t be required, according to one of the people, who asked not to be identified because the talks aren’t public. Discussions now center on how much of the government’s preferred shares in the firm must be converted into common stock, the person said. Under a plan set in February, the government would convert as much as $25 billion of its stake, for a 36 percent voting interest.

Getting money from private backers may help Citigroup dissuade the Treasury Department from converting all or part of its remaining $27 billion investment -- a step that may increase the government’s ownership to more than 50 percent and nationalize what was once the biggest U.S. bank. One likely solution for the company would be to convert $10 billion of privately held securities that could easily be added to the pending exchange, said Kevin Starke, who analyzes bank capital structures for hedge-fund clients of CRT Capital Group LLC.

“That would bring in another $10 billion of common equity, which could be enough to bring Citi over the threshold” required by regulators, said Starke, whose Stamford, Connecticut-based firm specializes in evaluating multiple classes of a company’s securities. He has no rating on Citigroup’s stock.

Government Control

Jon Diat, a Citigroup spokesman, said he couldn’t comment on the stress tests. Michelle Smith, a spokeswoman for the Federal Reserve, which is overseeing the administration of the stress tests, declined to comment.

None of the largest U.S. banks has succumbed to government control, as insurer American International Group Inc. and mortgage-finance companies Fannie Mae and Freddie Mac did last year. The Treasury Department designed the Troubled Asset Relief Program, or TARP, so the government got non-voting preferred shares in exchange for bank-bailout funds.

The KBW Bank Index, which tracks the 24 biggest banking stocks, has plunged 57 percent in the past year, partly on concern that banks don’t have enough common equity, one of the most conservative measures of capital, to absorb mounting losses during a prolonged recession.

Geithner’s Test

Treasury Secretary Timothy Geithner, who on Feb. 10 announced a plan to test how bank balance sheets would fare under a “stress” scenario where unemployment climbs above 10 percent, says the government will ensure the 19 biggest U.S. banks get enough capital to withstand the crisis.

The government says it will inject additional capital where needed and consider converting TARP preferreds into common stock.

Last year, the Treasury amassed $45 billion of preferred shares in Citigroup in exchange for bailout funds and another $7 billion of preferreds for a guarantee on $301 billion of the bank’s troubled loans and bonds.

Bank of America Corp., which like Citigroup got $45 billion of bailout funds, also may wind up partially owned by the government if its TARP preferreds are converted into common.

Bank of America hasn’t received a “final number” from the Fed on how much capital it may need to raise, spokesman Scott Silvestri said today in an interview.

Citigroup Losses

Citigroup, beset by mortgage-bond writedowns and surging losses on credit-card loans, has recorded a $36 billion net deficit over the past six quarters, reducing its tangible common equity to $29.7 billion as of March 31.

Some investors say tangible common equity is the most reliable portion of a bank’s capital because it excludes goodwill, the intangible asset booked when a company makes acquisitions. Goodwill may have to be written off in a market where the value of acquired businesses becomes suspect.

Chief Executive Officer Vikram Pandit, 52, has announced a plan to sell “non-core” businesses to free up capital. Last week the bank said it would get a $2.5 billion boost to tangible common equity from the sale of its Japanese brokerage, Nikko Cordial Securities.

The bank also is selling majority control of its Smith Barney brokerage to Morgan Stanley, a transaction that will add another $6.5 billion to Citigroup’s tangible common equity. That deal is scheduled to close in the third quarter.

Recession Scenario

Regulators completing the stress tests are working with banks to forecast profits and losses over the next two years. The goal is to see how much their capital would dwindle in a severe recession, and force them to address any potential shortfall. The results are scheduled to be released May 7.

It’s still unclear how much capital the government will make Citigroup raise, David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller in New York, wrote in a note today.

Citigroup may not be getting advance credit for $7.5 billion of securities held by the Abu Dhabi Investment Authority, Trone wrote. Those will convert into common equity in 2010 and 2011, Citigroup Chief Financial Officer Edward “Ned” Kelly said in a conference call on April 17.

The government also might be assuming a complete or partial write-off of Citigroup’s $43 billion deferred tax assets, essentially a tally of past losses that the bank says it might be able to credit against future tax bills, Trone said. “Perhaps the government is subtracting all this from capital,” Trone wrote.

Citigroup’s Plan

Under Citigroup’s plan to convert $25 billion of the government’s investment into common stock, holders of about $27 billion of privately held preferred shares also will convert their stakes. Citigroup induced the private holders to participate by suspending dividends on the preferreds -- eliminating an advantage the securities had over common stock. The bank also agreed to convert the preferreds at a premium to their market value.

Citigroup may make a similar offer to holders of about $10 billion of enhanced trust preferred securities, known as E- Trups, which rank above regular preferreds in repayment order, according to CreditSights Inc. analyst David Hendler. The E- Trups are a bond-like security whose coupon can be deferred for 10 years without triggering a default.

Stock Offering

Markets aren’t likely to warm to a secondary stock offering, and the bank may have trouble attracting investors who aren’t already entangled, he said.

“It’s hard to get third parties involved if the investors who are already there haven’t had their pound of flesh extracted,” Hendler said. “And the next class of investors to be in that donation mode are these E-Trups holders.”

Since the E-Trups are trading at 40 to 60 cents on the dollar, holders probably would come out ahead if Citigroup expands its exchange offer to include them, according to CRT’s Starke.

“They just need to open the window wider,” Starke said.

Such a deal would come at the expense of common shareholders, who already have watched the stock price tumble 94 percent since the end of 2006. Under the existing conversion plan, common shareholders would be diluted by 74 percent, and the dilution would increase if additional preferred holders were invited into the exchange.

Citigroup gained 23 cents, or 7.7 percent, to $3.20 at 4:11 p.m. in composite trading on the New York Stock Exchange.

Citigroup’s E-Trups issued in December 2007 with an 8.3 percent coupon surged 12 percent last week to 61.5 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Today the securities climbed another 4 percent to 64 cents on the dollar, according to Trace.

To contact the reporter on this story: Bradley Keoun in New York at bkeoun@bloomberg.net.

Last Updated: May 4, 2009 16:13 EDT